Defined Benefit Annuity and Whether To Take Lump Sum

The term ‘defined benefit’ tells us what sort of pension annuity income and lump sum you will receive i.e. it has already been ‘defined’ by being written contractually in the scheme rules.

If you have worked for a larger employer, local and central government, public service or military in the last you may likely have a defined benefit scheme.  For the last 20 years or so, these types of schemes have been in decline, as they are so expensive for employers, and replaced by investment linked, money purchase pension schemes.

Defining the Benefit

Usually, you accrue rights to a pension based upon the period of time that you were employed and a member of scheme.  This is calculated usually as a fraction of your salary and known as the accrual rate.

A 1/60^th scheme:

For each complete year, you are guaranteed to receive 1/60^th of your salary as a pension.  E.g. after 30 years, you will have accrued 30/60ths of your salary i.e. your starting pension is half i.e. 50% of your salary.  You are usually also allowed the option to take a lower starting pension i.e. sacrifice your pension to receive a tax free lump sum of no more than 2.25 x your pension.  In the above example, if your salary was £40,000, that would mean a pension of £20,000 pa.  If you sacrifice £5,000 pa of pension, you would receive a pension of £15,000 pa plus 2.25 X pension £15,000 = £37,500 tax-free lump sum.

A 1/80^th scheme:

For each complete year, you are guaranteed to receive 1/80^th of your salary as a pension.  E.g. after 20 years, you will have accrued 20/80ths of your salary i.e. your starting pension is a quarter i.e. 25% of your salary.  For many 80^th schemes you will also have tax free cash added on top of this.  This is usually 3n/80ths of your salary where n = number of years.  In the above example this would (be 3 x 20 years)/80 = 60/80ths i.e. three quarters 75% of you salary as a tax free lump sum.

Lump Sum or Not?

The easiest way to work out a straight value for money or not calculation on whether the lump sum is efficient is to work out the ‘annuity rate’ on the tax-free lump sum.  In the above 1/60^th scheme example, by sacrificing £5,000 pa pension you get a lump sum of £37,500. 

• Basic Rate Tax Payer 20%: £5,000 pa income gross = £4,000 pa net.  (£4,000/£37,500) X 100 = 10.66% i.e. you would need to get 10.66% pa interest/investment return (and increasing) to match a net income of £4,000 pa.  It is likely you should not take the lump sum in this example.
• Higher Rate Tax Payer 40%: £5,000 pa income gross = £3,000 pa net.  (£3,000/£37,500) X 100 = 8.00% i.e. you would need to get 8.00% pa interest/investment return (and increasing) to match a net income of £3,000 pa.  It is likely you should not take the lump sum in this example.
• If the tax free lump sum offered was higher then it may be worthwhile taking the lump sum.

Many definitions of benefit and salary

The above two examples are quite typical schemes but there are other factors such as 1/40^th, 1/45^th, 1/100^th, 1/120^th schemes etc.

In addition, your pensionable salary may different:

• A fraction of final year’s salary including bonuses (a final salary scheme)
• A fraction of final year’s basic salary only (a final salary scheme)
• A fraction of average of the best three consecutive years salary (a final salary scheme)
• A fraction of average of all your yearly salaries in that job (a career average salary scheme)

There are many definitions of salary that schemes may use.

Other Benefits:

Spouse’s benefit:  There is usually a spouses benefit on your premature death e.g. 75% or 50% of your accrued pension paid to your spouse on your death.

Children’s benefit:  Sometimes included and a % again e.g. 25% of your accrued pension paid to your children on your death until they finish full time education or they reach a particular age e.g. 18 or 21 years old.

If you have no children or spouse, on your premature death, your pension may disappear with you and be retained by the pension scheme.

Inflation benefit:  Most defined benefit schemes offer some form of revaluation or inflation protection.  If you leave employment and the pension scheme for another job, your accrued pension is legally required to be revalued e.g. LPI (limited price indexation) i.e. the benefit still increases at say the lower of 5% or inflation or for more recent service, the lower of 2.5% or inflation. 

Pension in payment:  In the same way that your benefits will still increase after you have left, when your pension is paid it will usually have some or all of your accrued pension inflation protected.  For some older service periods going back to the 1980s, there may not be any inflation protection but for service from the 1990s, there is usually pension in payment increases at either CPI (consumer prices index) or inflation.

Transfer Value:  You are legally allowed for most defined pension schemes (not local/central government/public service or crown service pensions) to transfer the cash equivalent value of the pension scheme to a private or company pension scheme of your own choice.  This is a highly complex matter with strict rules on transfer advice that will be expensive as most people should not give up their guaranteed, ‘gold plated’, inflation linked pension for a non-guaranteed, investment linked pension unless there are overriding reasons to do so e.g. serious/life shortening illness, no dependents, huge amounts of wealth and guaranteed income from other sources meaning you do not need this guaranteed pension.  Transfer value are extremely high currently and it is tempting to ‘take the money and run’ but for most people it will not be in their best interests to do so and the advice may cost you many £000s.